The (dot) plot thickens

By: Patrick O’Toole, Adam Ditkofsky and Pablo Martinez

Economic data

The Federal Reserve’s guidance to investors about where it sees the Fed funds rate going is transmitted via the dot plots that show each Fed governor’s expectations of where the rate will be at the end of each of the next few years and beyond. The latest release shows a majority of governors expects the Fed funds rate to rise to 5.25% this year, moving lower in the next couple of years, and settling in at around 2.5% over the longer run. Investors have been lagging the Fed’s guidance for the past year, and are now in sync with the Fed hiking its rate one last time on May 3 to the 5.00%-5.25% range. After that it remains a crapshoot, with the futures markets seeing cuts starting in Q4’23. The picture is similar in Canada, where the Bank of Canada remained on hold this week, but the futures markets see cuts by year-end too. Governor Macklem pushed back on that notion in his comments following the Bank’s meeting. But we’ve seen this story before, and if history is a guide, cuts to rates happen 2?4?quarters after the last hike. So, the futures markets are in sync with history.

And this week’s much anticipated release of the U.S. consumer price index (CPI) gave little reason to sway the Fed from hiking once more. Sure, the annual inflation rate dipped a full point, to 5% year/year in March, from 6% in February. But the Fed’s favoured measure of services inflation less food, energy and housing remained too high for comfort, at nearly 6% year/year. After one more hike, the Fed is expected to move to the sidelines as it assesses the impacts of hikes over the last year and the continued fallout from the Silicon Valley Bank debacle and continued tightening in lending standards. While the ripple effects from the latter have subsided, there has been a bank “walk” (as opposed to a bank “run”) as depositors continue to flee bank accounts for higher yields elsewhere. Already, the National Federation of Independent Business’ (NFIB) survey of businesses show that credit availability is deteriorating, and reports of concerns about the potential impact on commercial real estate (particularly office buildings) are growing, revolving around how property owners will refinance a coming tsunami of maturing mortgages in the sector. Adding to these concerns is that the stalwart of the economy, the U.S. consumer, is showing signs of exhaustion with this week’s release of retail sales and rising jobless claims. Higher interest rates and less pandemic related excess savings can be blamed for the more cautious consumer, setting up for a more challenging 2nd quarter for GDP after the surprising resilience seen in the first quarter.

Bond market reaction

It’s unheard of for the Fed to project a recession (isn’t that an acknowledgment that it’s failed in its mission?), but that’s what we saw with the release of this week’s minutes from the latest Federal Open Market Committee (FOMC) meeting. The Bank of Canada (BoC) is expecting a subdued growth backdrop north of the border in the 2nd?half of the year as the housing market and slower global growth take their toll on our more open economy. Despite the expectation that the BoC is unlikely to hike again and that the Fed will soon move to the sidelines, bond yields moved higher on the week, although the yield curve (10-year yield minus 2-year yield) became less inverse. That’s a normal pattern, whereby the curve starts to normalize, from being inverse, as investors price in coming rate cuts to help cushion the blow of recession.

The corporate bond market had an improved tone this week, allowing for credit spreads to move lower. The high yield sector saw a more meaningful decline in credit spreads as investors rallied on the view that the last hike is just around the corner in the U.S.

Stock market reaction

Global markets were positive this week with Europe leading the pack. Select companies have started reporting Q1 earnings, a set of results which will provide insightful detail on how to think about 2023 growth. To start, Louis Vuitton (LVMH) in France reported very strong earnings, with Europe and Japan growing 20%+. The strongest categories included retailing and fashion/leather goods. Individuals who can afford luxury goods continue to spend regardless of interest rate hikes and an uncertain economic backdrop. China remains an opportunity for LVMH in 2023 as consumers travel once again and resume spending habits. J.P. Morgan also reported earnings this week and mentioned they are not seeing material signs of a consumer pullback. In fact, over the last month, they have seen meaningful new account openings and inflows as a result of regional bank uncertainty in the United States. Their fortress balance sheet has often been touted, and management is leaning in on risk management as a differentiator. On the topic of J.P. Morgan, the investment bank was also the first financial giant to mandate senior staff’s return to the office 5 times a week, starting the end to remote working trends. The latter will eventually be a positive for commercial real estate.

What to watch next week

Canada’s March inflation report is due, along with housing starts. The U.S. sees the release of housing starts, building permits, existing home sales, and leading indicators.

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Patrick O’Toole is Senior Portfolio Manager, Global Fixed Income; Adam Ditkofsky is Senior Portfolio Manager, Global Fixed Income; and Pablo Martinez is Portfolio Manager, Global Fixed Income.

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